2005 Flow-of-Funds Data - I Report, You Decide

Households' cash outlays for goods, services and nonfinancial
assets (e.g. houses, SUVs) were approximately $662 billion more than their
cash inflows in 2005 - a record in dollar terms and a record 7.3% of
disposable income. The history of the dollar value of cash-inflow minus cash-outflow
is shown in Chart 1 as "net financial investment," which is defined
as households' net acquisition of financial assets (stocks, bonds, deposits,
etc.) minus the net increase in their liabilities (primarily, their borrowing).
To get a more intuitive feel for the concept of net financial investment, consider
the following equation:

From Equation (2), it follows that if households' borrowing is greater
than their net acquisition of financial assets, they must be spending more
on goods, services and nonfinancial assets than their cash inflow. As shown
in Chart 1, up until 1999, the height of the NASDAQ bubble, households had
always run a financial surplus - i.e., their cash inflow exceeded their
cash outlays. But starting in 1999, households have consistently run financial
deficits on an annual basis.

Chart 1

For the record, Chart 2 shows that households are now running a larger cash
deficit than the federal, state and municipal government deficits combined.

Chart 2

Chart 3 shows that the net increase in households' liabilities (their
borrowing) is at a record high 13.1% of their disposable personal income.

Chart 3

Chart 4 shows that a record $600 billion of households' borrowing in
2005, representing 6.6% of their dis posable personal income, came in the form
of cash advances from their home ATMs - that is, mortgage equity withdrawals.

Chart 4

Despite the rapid increase in the value of residential real estate in recent
years, the leverage in this sector remains at elevated levels, as shown in
Chart 5.

Chart 5

Some have argued that the leverage in residential real estate represents prudent
asset diversification. That is, households have been extracting equity from
their homes in order to purchase other financial assets. Chart 6 shows that
households might need some asset diversification in that residential real estate
in 2005 represented a record 31% of the market value of their total assets.
But if households are extracting equity from their houses for diversification
reasons, Chart 7 shows that they are not doing a very good job of it inasmuch
as households' net acquisition of financial assets as a percent of their
disposable personal income at 5.7% in 2005 remains far below the 1952 through
2005 median value of 10.7%.

Chart 6

Chart 7

Some argue that that even though households are taking on a lot of debt, the
values of their assets are rising, too. True, but as implied in Chart 8, households' debt
is rising at a faster pace than the market value of their assets, hence a record
leverage ratio of 18.6% in 2005. If the market value of their assets were to
fall, as it did in 2001 and 2002, households' leverage ratio would move
still higher unless they liquidated debt, which, in all likelihood, would accelerate
the decline in asset values.

Chart 8

Some argue that the buildup in household debt is of little concern because
the interest rate on the debt is relatively low. Chart 9 suggests that households
must have been "making it up on volume" in that the amount of required
principal and interest they must pay represented a record 13.71% of their disposable
personal income in 2005. According to David Rosenberg at Merrill Lynch, approximately
$2-1/2 trillion of household debt, or 21% of outstanding household debt
will reprice (up) in 2006. Unless there is a surge in disposable personal income,
the already-record high debt-service ratio will move still higher in 2006.

Chart 9

Some have argued that the Fed has become a serial asset bubble "blower." After
the stock market bubble it had allegedly created burst in 2000, the Fed then
aided and abetted the creation of a housing bubble. Although not proving these
assertions, the data in Chart 10 do show the relative extremes in asset prices
in the past ten years.

Chart 10

Some argue that households can and will maintain high growth in their spending
because their net worth has rebounded from three consecutive years (2000 through
2002) of declines. Chart 11 shows that relative to disposable personal income,
household net worth is almost back to its 2000 level.

Chart 11

But what is not mentioned is that these gains in household net worth might
be somewhat ephemeral. There are basically two ways in which households can
increase their net worth - spend less than they earn or be fortunate
enough to own an asset (e.g., a NASDAQ stock or a house) that rises in value.
From 1952 through 2005, the median value of capital appreciation of assets
as a percent of the change in household net worth has been approximately 69%.
As shown in Chart 12, in the past 11 years, capital appreciation has consistently
provided an above-median percentage to changes in household net worth - NASDAQ
stocks being the big driver in the late 1990s and residential real estate in
the past five years. In 2005, capital appreciation accounted for 102% of the
increase in household net worth. If the inflation in house prices is slowing
and we are not entering a new super bull market in stocks, how will households
keep increasing their net worth going forward? Cut back on their spending?

Chart 12

Are these trends in household finances sustainable? I reported, you decide.

Paul L. Kasriel
Director of Economic ResearchThe Northern Trust CompanyEconomic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul joined the economic research unit of The Northern Trust Company in 1986
as Vice President and Economist, being named Senior Vice President and Director
of Economic Research in 2000. His economic and interest rate forecasts are
used both internally and by clients. The accuracy of the Economic Research
Department's forecasts has consistently been highly-ranked in the Blue Chip
survey of about 50 forecasters over the years. To that point, Paul received
the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic
forecast among the Blue Chip survey participants for the years 2002 through
2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five
of The Wall Street Journal survey panel of economists. In January 2009, The
Wall Street Journal and Forbes cited Paul as one of the few who identified
early on the formation of the housing bubble and foresaw the economic and financial
market havoc that would ensue after the bubble inevitably burst. Through written
commentaries containing his straightforward and often nonconsensus analysis
of economic and financial market issues, Paul has developed a loyal following
in the financial community. The Northern's economic website was listed as one
of the top ten most interesting by The Wall Street Journal. Paul is the co-author
of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank
of Chicago. He has taught courses in finance at the DePaul University Kellstadt
Graduate School of Business and at the Northwestern University Kellogg Graduate
School of Management. Paul serves on the Economic Advisory Committee of the
American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily
represent the views of The Northern Trust Company. The information herein is
based on sources which The Northern Trust Company believes to be reliable,
but we cannot warrant its accuracy or completeness. Such information is subject
to change and is not intended to influence your investment decisions.